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Friday, August 22, 2008

Small Effects Add Up

I enjoy playing low stakes poker for fun. I’ve even tried it in casinos in Las Vegas. Part of the ritual in casino poker games is that the dealer takes a cut of a few dollars out of each pot, and the winner of each hand often gives the dealer a tip of a dollar or two. This gives a good illustration of how small things can really add up.

In low stakes games the players are often very impatient. I found that I could make about $20 per hour by simply being patient and disciplined. Playing this way is boring, but slightly profitable.

To win this $20 each hour, I actually lose about $180 and win $200. Of course, the winning and losing occur randomly, and it took many hours of play before I considered these average figures to be fairly reliable.

The problem is that the casino’s cut and the dealer’s tip come out of the $200 rather than just the $20. My “gross earnings” are actually more like $40 per hour. Even though the cut and tip are just a small fraction of each pot, they eat up about half of my winnings.

Similarly, a 2% management expense ratio (MER) on your mutual funds will eat up about half of your retirement savings after 35 years. Small amounts add up.

The next time you decide to spend $10 on expensive coffee and something to munch on, just remember that the cumulative effects of this spending may be the reason why your finances are keeping you awake at night.